What is a Default - A Pakistan Scenario

Asad Ejaz Butt in The Dawn

When Pakistan’s dollar reserves fell below $5 billion in December, and its credit default risk had reportedly become too high for analysts to ignore the possibility of an imminent default, the central bank made a policy decision to allow the opening of import letter of credits (LC) in a staggered manner to ensure spreading of the dollar reserve over a longer period of importing time.

The idea was to allow the government some diplomatic time to knock on the doors of friendly countries and multilateral organisations, including the International Monetary Fund (IMF). The Fund had dilly-dallied on the ninth review to force monetary authorities in Pakistan to take the first steps towards a few baseline reforms, including the relegation of the dollar to the markets. Markets that the central bank and the government regards as ripe with imperfections.

The rupee was finally devalued last week which automatically implied that it was left to a market that had the propensity to sell it to gain dollars. This provided IMF with the confidence to schedule the ninth review, which is now ongoing in Islamabad. It is likely that the IMF’s review will be completed, and default, as was predicted by some and wished by a few others, didn’t happen.

However, while the media thundered about the staggeringly high levels of inflation and alarmingly low levels of reserves, and analysts evaluated an infinitely large number of scenarios that would lead to a default, no one from the economists ever explained what a default meant and what would have happened to the economy if it took place. 

From the mid of November to the end of January, I was asked this question many times: “is Pakistan going to default, or has it already defaulted?” None of those asking the question seemed to know what it meant for a country to default and what would happen if it did. Last week, for the first time, someone asked me what Pakistan’s economy would have looked like under the influence of default.

Put in very simple terms, a default for a country like Pakistan with large exposure in commercial loans means defaulting against commercial debt. Bilateral debt can be rolled over, while debt from multilateral organisations often has long-term maturity cycles making a country’s default vulnerability depend primarily on commercial loans.

So, imagine if Pakistan’s reserves had declined to such low levels that it would have defaulted against its commercial debt. This would have led the central bank to refuse commercial lenders’ payments to repay or service their debt.

That would have reflected in the further downgrading of the country’s ratings by agencies like Moody’s and S&P, dampening the trust of other international lenders and, after that, the government’s ability to raise new commercial debt.

Since the dollar inflows would have declined due to limitations of debt inflows, you could have only imported as much as you exported plus the dollars that expat Pakistanis remit from all over the world. This would be like a situation where you are forced by circumstances to keep your current account deficit close to zero.

Many of the imports that you would not afford would be inputs to the industry. While that would impact exports, the slowdown would impact production in the non-exporting sectors, pulling down the overall level of production in the economy. The natural consequence of all of this is the classic saga of too much Pak­istani rupee chasing too few goods.

Inflation would have skyrocketed as the local currency that people would be holding would not translate into consumable items. Contraction in the economy due to production losses would have seen many people get laid off in a span of weeks, leaving some with money but nothing to buy and many without even money to buy. Economists call such situations characterised by slow growth but high unemployment and inflation ‘stagflation’.

This was played out in Sri Lanka in the summer of 2022. It suspended repayments on about $7bn of international loans due out of a total foreign debt pile of $51bn while it had $25m in usable foreign reserves.

Pakistan has around $3bn in reserves against an external debt pile of $126bn. Pakistan, in December 2022, was definitely headed in the Sri Lankan direction. However, we did not default and any chance of doing so has been left far behind.

Reviving even mere inches away from default is a world different to an actual default since, in the former case, you can resume business as usual as soon as a multilateral like the IMF returns with a few dollars in hand. However, in the latter case, even multilateral balance of payments support will take years to rebuild the economic edifice.

Pakistan didn’t default, and those who thought what happened to Pakistan in December of 2022 was a default must realise that a real default would have been much scarier than a few hundred LCs being opened with delay.

This piece is based on several conversations held with Mubashir Iqbal and Haider Ali.

If only Britain had joined the euro

If Gordon Brown had chosen to join the single currency 10 years ago, both the European Union and Britain would be stronger now

• 
• • Will Hutton
  • The Guardian, Thursday 13 June 2013 19.30 BST

Gordon Brown with Paul Boateng and Dawn Primarolo in June 2003, just after his ‘not yet' decision on joining the euro. Photograph: Sean Smith for the Guardian

Ten years ago this week Gordon Brown said no to joining the euro. It is an anniversary on which Bank of England governor Mervyn King, Ukip's Nigel Farage, Unite's Len McCluskey and the Guardian's Larry Elliott, along with most of the British economic establishment, can all agree. On this, Brown was right.

Elliott set out the establishment consensus in a classic piece this month on his alternative history of what would have happened had Britain joined. Essentially, he says, there would have been a bigger boom in the runup to 2007 and a more disastrous bust. Britain would now be struggling to maintain its membership as anti-EU sentiment mushroomed, prompting its eventual exit, dramatising the inherent unsoundness of yoking disparate economies into one inflexible currency.

But there is a more optimistic, alternative history. The first obvious point is that Britain could have joined the euro only if a referendum had been won. A victory would have depended on it being an obvious good deal, with the pound entering at a competitive rate and the euro's structure, rules and governance reformed to accommodate British concerns and interests. The European Central Bank would have needed to look more like the US Federal Reserve, with more scope for fiscal and monetary activism. The Germans would doubtless have insisted, in return, that the EU banking system be more conservatively managed.

The last decade would have been very different. What none of the mockers of the euro ever acknowledge is the economic doomsday machine that Brown created through not joining. By not locking in a competitive pound, Britain suffered a decade of chronic sterling overvaluation, made more acute by the City of London sucking in capital from abroad to finance the extraordinary credit and property boom of those years.

Imports surged and exports sagged; the economy outside banking, which made goods and services to be sold abroad, either stagnated or shrank. Much of the best of UK manufacturing was auctioned off to foreigners. Today we find that, despite a huge currency devaluation, there are just not enough companies to take advantage of it: too much of the rest of British capacity, thanks to foreign takeover, has become a part of global supply chains that are indifferent to exchange-rate variation. Our export response has been feeble; evidence of the economic orthodoxy's inability to devise policies and structures that favour production.

Inside the euro, at a highly competitive exchange rate, Britain's exports would instead have soared, and its traded goods sector would have expanded, not shrunk. Regional cities would have boomed around sustainable activity rather than property and credit. The euro's rules would have meant a less reckless fiscal policy, and banks would have been more constrained in lending for property. They would have had to lend proportionately more to fast-growing real enterprise, reinforced because the new rules would have required them to lend in a more balanced way.

Britain would have entered the 2008 crisis with a far less unbalanced economy, a stronger banking system and international accounts, and a government deficit much less acute. And the reformed eurozone could have responded much more flexibly and cleverly than it did.

In any case, both Britain and Europe are now wrestling with depressed economic activity caused by overstretched bank and company balance sheets – and the exchange-rate regime is hardly the cause of this distress. Germany and the stronger EU countries are plainly wrong in their overemphasis on austerity as a solution, but surely right to argue that the only long-term solution is for the whole of Europe to move to their productivist, stakeholder capitalism.

British mainstream commentators see the obvious fissure between the stronger European north and the weaker south as proof positive that the euro is fatally flawed. But suppose countries like Greece or Ireland rise to the German challenge? Already there are encouraging auguries in both. If so, notwithstanding excessive austerity, they could weather the crisis, and become stronger.

There is plainly a chance one or more countries could leave, but there is a greater chance the system in some form will hold – it is in too many countries' interests to avoid failure. Then expect a pan-European recovery to begin in the second half of the decade that will gather strength in the 2020s.

Inside the euro for the last decade, the economic and political debate would have necessarily moved on. Having won a historic referendum decisively affirming Britain's future in Europe, the Blair government would have had to think in European terms about how to produce, invest, innovate and export. Sure, there would have been problems. But Britain outside the euro in 2013, with endless spending cuts, the biggest fall in real wages for a century, 500,000 people relying on food banks, and a weak unbalanced economy, is hardly a land of milk and honey.

Emboldened by his referendum victory, Blair could have sacked Brown before the disastrous second phase of his chancellorship and lacklustre prime ministership. Blairism would have morphed into a new form of European social democracy, fashioning British-style stakeholder capitalism. UK politics would not have moved so decisively to the right, with conservatives preaching free-market Thatcherism while the left clings to a bastard Keynesianism – united only in their belief, against all the evidence including Britain's export performance, that floating exchange rates are a universal panacea.

A single currency demands disciplines and painful trade-offs: but floating exchange rates after a financial crisis are a transmission mechanism for bank-runs and beggar-my-neighbour devaluations. Magic bullets do not exist. Had Britain joined, both we and Europe would have been better placed, and Larry Elliott would now be writing about how better to get Britain to innovate and invest under a fourth-term Labour government. A better world all round.

My Weltanschhaung - 11/2/2012

I am glad that atleast now a few Greek politicos have called the bail out terms extortionate. I think Greeks should default on their loans. Else, where is the risk for the lender who seems to get his money back in all circumstances and even by hurting innocent victims in a society.

A more disturbing news is that Chinese imports (of raw materials, I presume) fell in January. This will worry all export led growth oriented countries, unless they are beating China at their own game. Unlikely though since Chinese firms enjoy state subsidised capitalism.

Harry Redknapp seems to be inching towards the England managership. I suppose every man rises to a level of failure, but it won't be Harry's fault as there appears to be a shortage of talent in England.

Argentina accuses the UK of storing nuclear weapons near the Falklands. At the same time the UK tries to prevent Iran and others from getting nuclear weapons.

The global outlook for oil appears gloomy, so will the energy suppliers lower retail prices?